Sunday, March 15, 2015

The Berkshire Hathaway annual letter to shareholders was released this past Saturday. Now, this is somewhat of an event all in itself for capitalists all around the globe. Even if you’re not a shareholder of Berkshire Hathaway Inc. (BRK.B), one looks forward to any dribble or drop of knowledge from the greatest known investor of all time, Warren Buffett.

I’m don’t own any BRK stock, so I’m not a shareholder. And that’s due primarily to the fact that shares do not pay a dividend and thus do not fit my goals/needs/desires. However, that doesn’t mean I’m not a huge fan of all things Warren Buffett. And I say that not just in the business or investing sense, but also in the lifestyle sense.

As such, I’m as excited as anyone when it comes to reading the letter. I love to comb through it for any new potential tidbits of wisdom. I haven’t read anything particularly groundbreaking in quite a while from Buffett, but that’s because the guy’s just so consistent in his belief system, which is something I admire and try to emulate to a degree.

However, this letter was groundbreaking in one way: It marks the 50th anniversary of Buffett – through Buffett Partnership Ltd. – taking control of Berkshire Hathaway (then just a struggling textile manufacturer) and slowly turning it into what it is today. An incredible story, no doubt about it.

Whereas a substantial portion of the letter reflects on the past, present, and future of Berkshire via Buffett’s perspective and a supplement from Vice Chairman, Charlie Munger, I’m going to focus today’s article on a particular section of the letter that happens to be more general investment advice that’s as sage as ever.

On page 18 Buffett takes a moment to discuss investing, stocks, risk, and volatility; and how someone with a long time horizon should really be investing:

The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is farfrom synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

It is true, of course, that owning equities for a day or a week or a year is far riskier (in both nominal and purchasing-power terms) than leaving funds in cash-equivalents. That is relevant to certain investors – say, investment banks – whose viability can be threatened by declines in asset prices and which might be forced to sell securities during depressed markets. Additionally, any party that might have meaningful near-term needs for funds should keep appropriate sums in Treasuries or insured bank deposits.

For the great majority of investors, however, who can – and should – invest with a multi-decade horizon, quotational declines are unimportant. Their focus should remain fixed on attaining significant gains in purchasing power over their investing lifetime. For them, a diversified equity portfolio, bought over time, will prove far less risky than dollar-based securities.

This is really great stuff here.

It seems, for whatever reason, that volatility is often synonymous with risk for most people. I’ve never viewed it that way. Volatility has never been a proxy for risk, in my view. I’ve never looked at a stock with a low beta (a measure of a stock’s volatility against the broader market) and thought to myself: “Yes, this stock isn’t volatile! It must also be low in risk”. If anything, I bemoan the lack of volatility. As I’ve often said, I view volatility as synonymous with opportunity.

Risk can be difficult to quantify. But when looking at stocks, volatility is about the last place I look to in terms of assessing risk. Fundamentals, competitive advantages, market share, debt, size, regulation, and competitive environments tell me a lot more about risk than volatility does. That’s for certain.

When I think of risk, I think of permanent loss of capital. Risk, to me, is the odds of losing money. That’s risk. When I look at an investment’s prospects, I immediately think of the odds that I’ll somehow permanently lose money (factoring in inflation as well). And that goes not just for ending with less money than I started with, but also opportunity costs. If I could invest in Opportunity X, but Opportunity Y will provide far more returns over the long haul (even if the ride is bumpier), then Opportunity X is technically more risky because I’ll technically be losing money. Thus, cash is risky to me. Putting cash under the mattress is an incredibly risky way to handle your wealth because you’re absolutely guaranteed to lose money over time due to the ravages of inflation. The opportunity costs of cash in comparison to high-quality stocks is enormous. Complacency is expensive.

However, volatility is often (always?) seen as a proxy for risk. Thus, most investors diversify into fixed income to reduce risk because it tends to be a much less volatile asset class. But the real risk there, as Buffett is pointing out, is lost returns. You’re essentially paying for reduced volatility. So while one assumes they might be reducing risk, they’re actually increasing it.

I’ve discussed before that I’m 100% invested in stocks. Other than cash to run my day-to-day life and a little on the side for emergencies, my asset allocation is 100% equities. But that comes with an important caveat: I’m a young, long-term investor. Furthermore, I look forward to volatility. There’s a certain personality that does well with going all-in on stocks. If you don’t have it, admit it and spread yourself out. Because you’ll do more harm than good thinking you can be invested heavily in equities only to doubt yourself at the wrong time, which is something Buffett expounds just after the paragraphs cited above. In addition, be mindful of where you’re at. A 70-year-old living off of the income their portfolio provides is a very different life situation than a 32-year-old asset accumulator.

As I was just mentioning in my recent Freedom Fund update, the lack of volatility over the last couple of years has come at the cost of effectively being able to put fresh capital to work. Thus, anyone who’s actively accumulating assets should certainly welcome volatility on a somewhat regular basis. Unfortunately, volatility doesn’t work like that. It tends to come around when you’re least expecting it and least ready for it.

In the end, stocks – specifically high-quality stocks – is one of the greatest investment classes you’ll find in the entire world. 100+ years of returns will tell you that. Every dollar funneled away from excellent stocks is very likely an opportunity cost. If that opportunity cost is worth reducing volatility for you, then by all means proceed. But that opportunity cost is too large for me. Thus, all of my capital is working extremely hard for me in the form of equity in some of the best businesses in the world. Even better, each one of these businesses is regularly raining cash upon mein the form of dividends. Not only that, but those dividends are growing by virtue of growth in the underlying businesses’ profits. So while it all started off as a drizzle, I can now say with some confidence that it’s turning into a full-fledged thunderstorm. And guess what? I don’t have an umbrella.

What do you think? Was the letter another classic? Do you view volatility as a proxy for risk?